Where is the Anxiety Ahead European Political Risk on March 4?

Among the biggest political risk of the year is at hand. The results of the SPD vote on whether to join another grand coalition and the national election of Italy are due Sunday. The market is unusually calm about it.

The euro is trading sideways, a couple cents below the multi-year high set two weeks ago near $1.2550.Speculators in the futures have hardly pared back a record net long position (263k contracts in late January vs. 239k as of February 20).

Italian bonds and stocks have generally done well.Its shares have outperformed both Germany and Spain in the run-up to this weekend as well as year-to-date. Italy’s bank share index has risen 11.4% year-to-date.

Since the start of the year, the 10-year Italian yield has risen 1.4 bp. The yield on a similar obligation from Spain is flat and the German yield is up more than 24 bp. Italy’s 5-year credit default swap finished last year near 118 bp. It was at 105 yesterday, and was down to near 96 bp a few days ago.

Surely some one is concerned the SPD could reject the grand coalition, which would leave Germany with either a minority government or new elections. Recent polls warn that the SPD’s support has continued to wane since last September’s election and that is is slipping behind the AfD. The SPD can not chose to be in a grand coalition, but if a new election is required, it may not have enough votes, which would likely require participation of the FDP or Greens.

One place where some anxiety is being expressed is in the short-dated euro options. It appears participants are buying options because volatility is firm even though the euro has been stuck in a range in recent days. The premium of one-week euro puts has risen sharply over euro calls.

Longer-dated implied euro volatility is heavy.In fact, it is quoted now near its lowest level in a month (~7.15%). It peaked near the middle of the month near 8.5%, which was the high since last April. The one-week implied volatility, which as of yesterday covers the coming week’s political events, is at 9.05%. It finished last week near 7.3%.

In the options market, participants are have been paying premium to buy puts instead of calls, equidistant from the money (25 delta) since earlier this month (February 7). Before the weekend, the put premium was 0.095%. It increased to 1.67% yesterday, the most since last May. It is quoted near 1.10% now. The three-month skew (risk-reversal) favors euro calls slightly (~0.035%).

The takeaway is that some investors may be more concerned about the political risk from this coming weekend’s events.However, there is a general belief that the SPD will support joining a grand coalition. The polls in Italy before the quiet period showed the center-right coalition poised to get the most votes, while the center-left may secure more seats. It may take a while, perhaps not as long as Germany (five months and counting ) or Belgium (over a year), but the net result would be a government not too dissimilar to what it has now. Investors, or most of them, seem to believe that whatever disruption takes place it will not be severe or long-lasting.

Of course, there is room for surprises. The SPD could decide not to participate in another coalition with Merkel, which is what party-leader Schulz had maintained in the immediate aftermath of the September election. He offered up his own chance to be foreign minister to the left-wing of the SPD to get their backing for a coalition. It looks like it was sufficient, but it might not have been.

In Italy, the biggest shock would be in the 5-Star Movement won a plurality of the votes. Another shock would be in the the center-right won a majority of vote (Berlusconi reportedly is hoping for at least 45%). The center-left leads the current government. A strong showing by it may ease lingering investor anxiety.

Marc Chandler joined Brown Brothers Harriman in October 2005 as the global head of currency strategy. Previously he was the chief currency strategist for HSBC Bank USA and Mellon Bank. In addition to frequently providing insight into the developments of the day to newspapers and news wires, Chandler's essays have been published in the Financial Times, Barron's, Euromoney, Corporate Finance, and Foreign Affairs. Marc appears often on business television and is a regular guest on CNBC and writes a blog called Marc to Market. Follow him on twitter.